The Bank of England announced yesterday that it would provide £10bn in emergency funds to the UK's commercial banks in an attempt to prevent a severe worsening of the credit crunch over the Christmas period.

With lending conditions already at their toughest for two months, the Bank's governor, Mervyn King, told MPs on the Treasury select committee that the "fragility in the banking system" meant further action might be needed over the coming weeks.

"We stand ready to take further measures in order to keep the overnight rate in line with the bank rate," King said, adding that the move was similar to measures announced recently by the US Federal Reserve and the European Central Bank. "We are keeping money markets under constant review," he added.

The Bank, which was criticised in some parts of the City for its hardline stance towards banks seen to have made poor investment decisions in the build-up to the credit crunch, said it would lend £10bn at the bank rate of 5.75% for five weeks in an auction that will take place on December 6.

Threadneedle Street normally makes funds available for only one week, but it is concerned that the need for banks to balance their books at the end of the year will drive up the cost of borrowing money. King believes that a new-found wariness among commercial banks about extending credit rather than an overall shortage of liquidity explains the widening gap between bank rate and the Libor rate - the level at which banks lend to each other.

The government is braced for a tougher economic climate, although Gordon Brown expressed confidence yesterday that the UK would eventually shrug off the impact of turmoil in the financial markets. Asked if the prime minister agreed that the economy faced an uncomfortable period, his official spokesman said: "These are testing times as a result of instability in financial markets, originating in the sub-prime markets in the US. No country can insulate itself from ups and downs, but because of the framework we have put in place, both the prime minister and chancellor are of the view that we remain well-placed to withstand shocks of this kind, just as we withstood the Asian crisis, the Russian crisis, the dotcom crisis and all the other economic shocks.

"He, working with the chancellor, will do everything to steer a course of stability in uncertain times for the world economy."

Yesterday, the gap between the bank rate and two-month sterling Libor widened to almost 0.85 percentage points - close to levels seen at the height of the Northern Rock crisis in September. Despite fresh injections of liquidity from the European Central Bank this week, euro Libor rates rose by more than half a point to their highest in six years.

"Given the continuing fragility in the banking system there is a risk that money markets will tighten over the end of the calendar year," King told the MPs.

While warning that the short-term outlook for the economy was "rather uncomfortable" and "highly uncertain", the governor said he did not think tighter lending conditions in financial markets were so far having a big impact on the investment decisions of British businesses.

However, he added, in the case of banks "there is general uncertainty about the potential liabilities of individual institutions to losses. No one quite knows where that is or how big the losses will be."

Despite signs of a re-intensification of the credit crunch, the City believes that the Bank's nine-strong monetary policy committee will delay cutting interest rates until the new year. Divisions on the MPC were highlighted when Professor David "Danny" Blanchflower said he was concerned about the impact that a US recession would have on the UK economy, but Professor Tim Besley said there were still inflationary pressure in the UK economy, which he feared could get "embedded in expectations and wage agreements".

King said the most likely outcome was for slower growth and higher inflation and admitted that the next few months were "far from straightforward".